How the Inflation Illusion Killed the CAPM

Modigliani and Cohn's (1979) hypothesis suggests that time-variation in the level of inflation causes the market's subjective expectation of the future equity premium to deviate systematically from the rational expectation. When inflation is high (low), the rational equity-premium expectation is higher (lower) than the market's subjective expectation. We test the joint hypothesis of Modigliani and Cohn's inflation illusion and the Capital Asset Pricing Model (CAPM). We show that an implication of this joint hypothesis is that the security market line (the relation between an asset's average return and its CAPM beta) should be steeper (shallower) than predicted by the Sharpe-Lintner CAPM when inflation is low (high). Our empirical tests support this hypothesis and offer an explanation for the CAPM's poor performance in the 1950's and 1980's